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Stagflation: an alternative diagnosis

October 11, 2006

Mea Culpa! I have seriously misread Dr. Shostak's piece as endorsing what he was actually presenting merely as his take on Phelps' flawed description of 'stagflation', namely:

"Individuals then begin to realize that there has been a general loosening in the monetary policy. In response to this realization, they start forming higher inflation expectations. Individuals realize that their previous increase in the purchasing power is actually dwindling. Consequently, the overall demand for goods and services weakens. A weakening in overall demand in turn slows down the production of goods and services while the rate of unemployment goes up — an economic slowdown emerges.... In short, the realization that there was a general loosening in monetary policy weakens the demand for goods and services"

As Dr. Shostak - ahem! - rightly points out, this is evidently incorrect.I say this, because this seems to imply is that once people realize that their money is becoming depreciated, they throw their hands helplessly in the air and stop trying to get rid of it as quickly as possible. That would be very strange behaviour, indeed!

Here, dressed up, we have an underconsumption argument and, ergo, nothing would seem more natural to a mainstream policy maker than to address this by increasing the money supply once more.

But, as usual in Austrian analysis, we must seek the cause of the crisis in the effects of intervention on producers, not consumers.

Dr Shostak does this, if in somewhat broad terms and with characteristic reference to his 'pool of funding' argument - an approach which offers a fine heuristic, but one which perhaps needs a little more elaboration.

Filling in the details, we find that stagflation comes about when a deceleration in inflation - or an enhanced estimate of its consequences - means factor costs start to rise more rapidly than do many firms' sales prices. This eventuates because the ease with which these factors are acquired under the deceptions of inflation has been ended as the factor owners cotton on at last to their own loss of purchasing power..

Put another way, we can say that owners of increasingly scarce resources and labour notice they are getting the worst of the deal and act to increase the reserve price at which they will offer their services.

Indeed, Hayek took delight in pointing out the paradox that it is an excess of consumption demand - not a dearth - which is what causes problems for long-timescale, higher-order goods providers who have been lured into over-expansion by loose credit conditions.

To the degree that it is the workers - especially unionized workers or state employees, of course - who succeed in raising their real wages in this struggle, unemployment is an inescapable consequence (costs up:demand down), despite the ongoing price rises occasioned by the monetary influx. Inevitably, the political response to such job losses is to inject another round of monetary stimulus, so repeating the whole sorry process.

Essentially, even as businesses stagger and fail because sporadic, if widespread, entrepreneurial errors have been induced by an inflation the first fruits of which they can no longer fully reserve to themselves, joblessness therefore rises.

Notwithstanding this, the more fortunate (or politically favoured) factor owners may be able to concentrate inflationary gains in their hands instead and so will seek to spend their swollen money incomes (under the circumstances, they are highly unlikely to increase their savings and so alleviate some of the tensions) on a flow of (consumer) goods which has either not increased rapidly enough to provide an offset, or, has perhaps even fallen due to the debilitating dislocations in the system.

The upshot of all this is that we end up with rising final goods prices and elevated unemployment - that, is: 'stagflation'.

Two quibbles remain: Dr. Shostak's contention that stagflation is the 'normal' or 'natural' result of a credit inflation (later in the piece, he himself lays out a scenario in which no 'visible' stagflation is evident) and his assertion that such an inflation can never boost growth.

While both contentions hinge (as ever!) on what exactly one means by the terms employed, the first is clearly not the case, for the boom may instead be run on at a faster and faster rate with no increase in unemployment, right to the point that a hyperinflationary breakdown results (as in the Weimar example).

Conversely, the exhaustion may be such that falling employment leads to lower factor incomes, falling consumer demand and, hence, lower final goods prices, once monetary restriction belatedly takes place.

As for the second idea, surely the whole theory of the boom is predicated upon the very fact that extra credit does indeed tend to generate extra output, employment, and income - in the short term.

Further, to the extent that new goods and services do happen to appear in a timely enough manner, as a consequence; or to the degree that people decide (even if gulled) to save some of their extra income after the event, this may not be accompanied by any noticeable rise in final goods prices at all (qv the China syndrome over recent years).

Be that as it may, it must be stressed most emphatically that both the practical dangers of the disproportionality involved and the qunintessential moral inequity of the policy means it can provide no credible estimate of the expansion's effectiveness in providing any net benefits, nor does it offer any solid justification for embarking upon it in the first place.

Let me conclude by apologising once more to Dr. Shostak for not taking the trouble to read his work in a more considered fashion before rushing into print!

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